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So you’ve just joined the world of being an “accidental landlord.” Maybe you had to relocate, or perhaps you had to downsize. Now you’re renting out your personal residence or second home instead of selling it.

Tax time clockThis makes you a landlord in the eyes of the IRS, which means you’ll have to report the rental property on your federal income taxes.

So what’s a landlord to do?

Fortunately, most rental property ownership will initially generate taxable losses for you, which may save you some money on your taxes. These savings come from shielding, or deducting, losses against part of your regular taxable income. But keep in mind, taxable losses are different from positive or negative cash flows (and that’s a story for another day).

For our purposes, we’re just going to discuss what you need to do as a newbie landlord to get your taxes heading in the right direction.

Income and expenses

Next April you’ll add an IRS 1040 Form Schedule E (Supplemental Income and Loss From Real Estate) when you file your taxes.

On the Schedule E, you’ll record all the rental income you received for the prior year. Then you will record all the cash expenses related to the property: mortgage interest, property taxes, HOA fees — which are now deductible because it is a rental property instead of a personal residence — maintenance and repairs, gardening costs and any other expenses, such as depreciation (described below) that are related to the operation of  your “business.”

The net rental income, less all those expenses, will provide an income or loss figure that will be calculated on Schedule E and flow to your IRS 1040 Form, Line 17. So if rental income is $15,000 and expenses are $17,000, you have a $2,000 loss for tax purposes.

Depreciation

One favorable expense deduction that you can take against rental income is called depreciation. It is usually a large amount and can help you greatly decrease the taxes you pay. To figure out this amount, first you need to determine the tax basis and depreciable basis of your rental property. The tax basis will generally be what you originally paid for the property, plus any capital improvements you’ve made over the years. So if you paid $200,000 and put in a $25,000 addition, your taxable basis is $225,000.

You’ll then split that basis into land value and building value, which is your depreciable basis. Divide that building value by 27.5 years to get your depreciation deduction, which goes on your Schedule E just like any other expense. Make sure to have a tax preparer help you with this calculation.

Adding it up

Now let’s look at how the Schedule E income or loss flows to your main 1040 form. You would take your net income or loss on the Schedule E form and transfer it to your 1040. If it’s a loss, you save money on taxes. If it’s positive income, you pay additional taxes.

Note: On losses there are some “Passive Activity Loss” limitations on using losses to shield income. The net maximum loss you can use to shield income is $25,000, and the ability to use any losses phases out starting at $100,000 adjusted gross income. Real estate professionals, however, may be able to use unlimited losses. Talk to a tax professional on all these issues.

Even though your new landlording career may be an accident, being smart about the relevant income tax deductions shouldn’t be. Do some Internet research, talk to your tax professional, look at the Schedule E form, save all those receipts and make sure you maximize your deductions, especially depreciation, so you get the largest possible tax savings the IRS code allows.

Related:

Leonard Baron, MBA, is America’s Real Estate Professor®. His unbiased, neutral and inexpensive “Real Estate Ownership, Investment and Due Diligence 101” textbook teaches real estate owners how to make smart and safe purchase decisions. He is a past lecturer at San Diego State University and teaches continuing education to California real estate agents at The Career Compass.

Note: The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinion or position of Zillow.

  • http://www.influenceinvesting.com John Sheldon

    Thanks for the great tax information, Leonard. What I would like to address here is that people need to take into account the expenses of vacancies and repairs over the long run in rental property, even single family homes.

    On average, people can expect that vacancies and repairs will cost a minimum of 25% of the monthly rent. Now, this will not happen every month, it may not even happen every year, but over the long haul, these expenses are going to happen and need to be taken account for as far as your own cash flow is concerned. So don’t just think that because your rent covers your mortgage and taxes that you are in a great position.

    Speaking of expenses, I also highly suggest that people use professional property management. For many, many years, I’ve managed my own property and I finally figured out and admitted to myself that I was not a good property manager and my time is best doing other tasks that I am better at.

    So, you heard it here, I highly suggest professional property management. It will help you in the long run. And thanks again, Leonard.

  • http://www.nononsenselandlord.com/ No Nonsense Landlord

    Great tips. Put the property in an LLC and enjoy even more benefits!

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